Each product that exists can be classified into a market in which it competes with other products for the attention of consumers. For instance, apples might be considered a snack-fruit and compete with items including pears and bananas. In other words, if the price of apples increased then demand would substitute towards one of these other products. The market for apples, would thus include these other fruits which substitution can easily happen.
Such substitution means that apple producers are restricted in their ability to increase prices. Increasing prices too much would result in this demand substitution towards other products.
On the other hand, other products might have a more restricted market. For instance, it could be argued that iPhones are their own market. In this case, they could increase prices and not seen a substitution away from their product. Although, there might come a point where if they increase prices by too much then demand does eventually substitute (towards other phone manufacturers).
This definition of the market has important implications for regulatory authorities, in particular in designating the boundaries of a market and what products to include and over which geographic regions. This is important when it comes to competition regulation in the sense of dominance cases or mergers. Most mergers are only permitted if the proposed merger does not result in the market share of the resulting firm breaching certain boundaries. The market share of the two firms will depend upon the definition of the market – defining the market narrowly would increase the market share, whilst the merging parties would argue in favour of a wider market, where their market share is naturally lower (and therefore means that the courts will more likely rule in their favour).
In the words of the European Commission’s Market Definition Notice, “the main purpose of the market definition is to identify in a systematic way the competitive constraints that the undertakings involved face”.
A quantitative method of determining the market is using the Small but Significant Non-transitory Increase in Prices test (also known as the hypothetical monopolist test). This test starts by limiting the product market of a good to be as small as possible and then asks what would happen if a hypothetical monopolist increased prices by 5 to 10%. If the price increase is profitable – i.e. demand does not decrease or it decreases by so little that the increase in revenue outweighs the lost custom – then the market is defined. If not, then widen the market definition by including the next closest substitute and then continuing the test until the price increase is profitable.
In this sense the SSNIP test identifies the narrowest market in which a hypothetical monopolist would be capable of profitably imposing a small but significant and non-transitory increase in price. The relevant product market should be a group of interchangeable products which may be profitably monopolised. If such a price increase is profitable for a product, or group of products, it means they are not subject to significant pressure from other products. If it is not profitable for a company which is the sole supplier to raise the price by 10 per cent then it means that the product is either highly interchangeable or there are other firms which can quickly supply the product (under such a price increase).
The price increase of 5 to 10% is chosen so that the price increase is not too small that it would have no impact on demand but not too large that it results in demand substitution for other products which do not actually compete with the product of interest at competitive prices.
To apply the SSNIP test quantitatively, precise economic data must be available to determine (a) the competitive level of prices which should be used for the test, (b) the profit margin of the hypothetical monopolist and (c)the cross-elasticity of demand and of supply between two products/areas. In reality, it is quite difficult to actually implement the SSNIP test as data requirements are often large. Alternatively, a regulator could look to see if a natural experiment can answer the question – has there been a recent time when an exogenous factor caused the price of the good to increase, and what was the effect of this. For example, if a natural disaster occurred which drove the price of the product up (by a small-ish amount), the demand patterns could be studied to see if consumers were able to substitute.
Obviously, there are many pitfalls with the test, for instance in determining the next closest substitute to a good. Failure to select the closest substitute could result in the SSNIP test concluding market definition without considering the necessary substitutes.
Another large detraction of the SSNIP test is known as the cellophane fallacy. Intuitively, we have said that if a hypothetical monopolist cannot profitably increase prices by a small amount in a market, then we must enlarge the scope of the market until this occurs. However, a profit-maximising monopolist is likely to have already increased the price sufficiently highly (until demand is no longer elastic) such that it is not profitable to increase it further. In this case, the SSNIP test would break-down as it would reveal that the market is wide, because firms substitute to other products. But they only do this because the price is too high, not because those other goods are genuine substitutes. A similar event can happen in the other direction – in predatory pricing cases, the practice of infra-competitive prices may also distort the results of the SSNIP test.
In practice, the SSNIP test is used as a framework to evaluate market definition but it is difficult to implement in a purely quantitative sense. Instead, a regulator may survey customers and key business insiders to examine their opinion of what would occur in the event of an SSNIP, without having to rely on actual data or to estimate various price elasticities.